The investment landscape is full of confusing jargon, but one area that seems to baffle investors more than others is fixed income. In today’s interest rate environment, clients repeatedly ask questions relating to bond pricing. Specifically, clients ask why they pay a premium for bonds, and how this impacts the return on their investment. In this brief post, we will look at some bond basics to help explain why buying premium bonds can actually be beneficial to your portfolio.
First, we examine some basic characteristics of bonds. Bond prices are quoted differently than most securities with the bond “price” representing the percentage of par value (ex. $1,000 or $5,000). For example, if a bond’s price is 110 and par value is $1,000, the bond’s price would be $1,100 or a 110% of the par value. If a bond trades above 100, it is called a premium bond. If it trades at 100, the bond trades at par, and if it trades under 100, it is a discount bond. A bond carries a stated coupon which is the amount of interest the bond will pay the holder each year (often paid semi-annually). Lastly, the yield-to-maturity for a bond tells the holder what annual return they will receive if they were to purchase the bond at prevailing market prices, and hold it until maturity.
If a bond is trading at a premium it means that it is paying a coupon above the level of current market interest rates, hence the buyer has to pay more for the higher interest. The bond market is efficient in that it will price two bonds paying two different interest rates in a way that the total return will be roughly the same when the bond matures (assuming all else equal). To show how this works, we provide the hypothetical example below. Bond A has a cost of $100, meaning it trades at par, and pays a 2% coupon which is in line with current market interest rates. Bond B has a cost of $101.96, meaning it trades at a premium, and pays a 4% coupon which is above the current level of market interest rates. After one year, when both bonds mature, they deliver nearly identical returns.
If the returns on the two bonds are essentially the same, why should we buy the one that cost more? First, because premium bonds pay higher coupons, they carry a lower duration, which means they are less sensitive to rising interest rates. When rates are rising these bonds will be more defensive and retain more of their value than bonds paying a lower interest rate. Also, if interest rates are rising, the higher cash flows produced by premium bonds can be reinvested at the higher interest rates.
Another issue that is important to address is the common misperception that investors “lose” the premium they pay for the bonds when it matures. This is not true as the higher coupons associated with premium bonds allow investors to recoup the higher cost of the bond through the interest payments.
The last point worth mentioning relates to the overall supply of bonds trading close to par. The issue of purchasing premium bonds mostly pertains to municipal bonds, since there is a healthy supply of corporate bonds trading close to par. The reason why municipal bonds often trade at premiums is rather straightforward. Issuers (municipalities) realize that bond holders often favor a higher level of tax-advantaged income meaning they will issue bonds paying above market coupon rates.
As always, we continue to monitor bond pricing to determine what is best for our clients. For the time being, we are comfortable owning premium bonds, and think they offer distinct advantages to our clients. If conditions change enough to alter our strategic view, we will certainly keep you informed.